Will The ECB Push Eurozone Small Caps Higher?

The good news in Europe is that the freefall in the periphery has been arrested and an anemic recovery has begun. The bad news is that the risk of deflation still hangs in the air.

Indeed, the latest eurozone inflation numbers came in under expectations. Eurostat reports that the December annual inflation rate was 0.8% (vs. an expected 0.9%) and core inflation was 0.7% (vs. an expected 0.8%). The undershoot raised the question of whether the ECB could take action to further stimulate the eurozone economy. The comment from Joe Wiesenthal of Business Insider is typical of the concerns raised by many market analysts:

The big fear in Europe used to be that the economy would collapse.

Now the big fear is that Europe is going to become Japan, an economic bloc mired in deflation and horrible growth.

European Central Bank President Mario Draghi said Monday [December 16, 2013] that any future long-term financing operation will be tailored to ensure the money reaches the real economy but warned it was a complicated scheme that the ECB must consider carefully.

Draghi went on to say that the ECB was considering an LTRO of a different sort, which targets SME lending [emphasis added]:

On the possibility of a conditional long-term refinancing operation (LTRO), Draghi said the ECB's original LTROs already included elements of the Bank of England's Funding for Lending scheme and noted there were "operational complications" involved in implementing such programs among 17 countries, rather than one country.

Draghi said that if the ECB were to engage in another LTRO, it would be "making sure that this money reaches the real economy and doesn't stop in the banks, or [result in] the banks buying bonds only."

The ECB had been monitoring SME lending and, in November, found that conditions were deteriorating despite the ample availability of liquidity. The ECB conducted a survey and came to three major conclusions:

Finding customers and access to finance remain the dominant concerns for euro area SMEs

SMEs report a marginal deterioration in the perceived availability of bank loans

Survey points to an increase in interest rates offered to SMEs, while conditions still differ significantly across countries

SME aid is small cap bullish

These concerns about SME lending are not new to the ECB. On Thursday, I would watch the ECB statement and Draghi's language as to how they might move on a conditional LTRO program. While no action is likely this week, we may get greater clarity on this issue as any central bank stimulus targeted at the real economy would be tremendously bullish for eurozone small cap stocks (see my previous post More reasons to buy Europe).

Already, the European small cap ETF (NYSEARCA:DFE) has been in a relative uptrend against its large cap counterpart (NYSEARCA:FEZ) which began in late 2012.

(click to enlarge)

Any hints of further ECB action in support of SME lending would likely spur further outperformance in European small cap stocks.

Full disclosure: Long DFE

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
PRO Alerts is our flagship product for individual investors who want to be faster
and smarter about their stocks. To learn more about it, click here.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!